Lending money involves risk. Regardless of who the borrower is, be it an individual, corporation, municipality, national government, or supranational organization such as the World Bank or the United Nations, there is always a possibility of default. In many cases the risk of default is remote. In others it is less so. Interest rates on loans are determined based on, among other things, a borrower's perceived ability to repay the loan. Paradoxically, a borrower whose ability to repay a loan is less certain will have pay more to borrow money in the form of higher interest rates than a borrower who is perceived to be less of a risk. Because debt plays a vital role in the world's economy, assessing risk is of critical importance to ensuring the desired flow capital from those who have it to those who would use it.
Over time, credit rating services have developed to assist lenders and investors in assessing risk and evaluating the overall credit worthiness of individuals and organizations. These credit rating services produce credit ratings for individuals and organizations that reflect the rated party's ability to repay its debts. Investors and lenders rely on such ratings when deciding whether to extend financing, and on what terms. In the United States, the Securities and Exchange Commission has relied on credit ratings by rating agencies that the markets have recognized as credible. These “nationally recognized statistical rating organizations” (“NRSROs”) include several major credit rating services, including A.M. Best Company, Inc. (A.M. Best), Dominion Bond Rating Service Limited (DBRS), Moody's Investor Services (Moody's), Standard and Poor's (S & P), and Fitch's Ratings (Fitch's).
The rating schemes followed by the three major rating services are all similar. Each includes multiple levels, with each level representing a different level of risk, or a different ranking of the perceived ability of a rated entity to meet its debt obligations. A 1 to 3-letter code identifies each of the different levels. For example Moody's defines nine primary risk levels:
Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C.
According to this system, the Aaa rating is reserved for the entities that demonstrate the strongest credit worthiness. Debt issuers or debt issues rated Aa demonstrate very strong credit worthiness but somewhat less than those rated Aaa, while rated simply those A represent above average credit worthiness. Issuers or issues rated Baa represent average credit worthiness. Those rated Ba demonstrate below average credit worthiness, and those rated B demonstrate weak credit worthiness. Finally, issuers or issues rated Caa demonstrate very weak credit worthiness. Those rated Ca demonstrate extremely weak credit worthiness, and those rated C demonstrate the weakest credit. Moody's also appends a numeric modifier 1, 2 or 3 to the categories Aa through Caa. The numeric modifiers indicate where within the particular risk category the entity being evaluated falls. 1 indicates the top rating within the group. 2 indicates the middle of the group. 3 represents the bottom. The modifiers 1, 2, 3 effectively expand the number of risk categories to a total of twenty-one.
S&P's alphabetic rating system is similar to Moody's. S&P defines its primary risk categories as:
AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
The definitions of S&P's categories roughly track those of Moody's and need not be explicitly related here. S&P append a (+) or (−) to categories AA to CCC in order to show an entity's relative standing within the major rating categories. With the modifiers, S&P's rating system effectively includes 16 different levels of risk.
Fitch also relies on a letter rating code similar to those already described:
AAA, AA, A, BBB, BB, B, CCC, CC, C, DDD, DD, and D.
Fitch also includes a (+) or (−) modifier to categories AA-CCC to indicate an entities relative position within a category. Thus, Fitch ratings may take on up to 18 different the levels.
The rating services monitor the financial health of the organizations they rate, updating their ratings as conditions warrant. If the rating services perceive a change in an organization's ability to meet its obligations the rating service may downgrade its rating of the organization. In contrast, improved financial circumstances may cause the rating services to upgrade an entity's credit rating. Thus, much like a company's stock price, an entity's credit rating may serve as a barometer of the entity's financial health.
Derivatives are financial securities whose values are derived in part from a value or characteristic of some other underlying asset or variable (the underlying asset). The underlying asset may include securities such as stocks, commodities market indicators and indexes, interest rate, and corporate debt, such as bonds, to name but a few. Two common forms of derivatives are options contracts and futures contracts.
An option is a contract giving the holder of the option the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. Generally, a party who purchases an option is said to have taken a long position with respect to the option. The party who sells the option is said to have taken a short position. There are generally two types of options: calls and puts. An investor who has taken a long position in a call option has bought the right to purchase the underlying asset at a specific price, known as the “strike price.” If the long investor chooses to exercise the call option, the long investor pays the strike price to the short investor, and the short investor is obligated to deliver the underlying asset.
Alternatively, an investor who has taken a long position in a put option receives the right, but not the obligation to sell the underlying asset at a specified price, again referred to as the strike price on or before a specified date. If the long investor chooses to exercises the put option, the short investor is obligated to purchase the underlying asset from the long investor at the agreed upon strike price. The long investor must then deliver the underlying asset to the short investor. Thus, the traditional settlement process for option contracts involves the transfer of funds from the purchaser of the underlying asset to the seller, and the transfer of the underlying asset from the seller of the underlying asset to the purchaser. Cash settlement, however, is more common. Cash settlement allows options contracts to be settled without actually transferring the underlying asset. A call option is “in-the-money” when the price or value of the underlying asset rises above the strike price of the option. A put option is “in-the-money” when the price or value of the underlying asset falls below the strike price of the option. An at-the-money option wherein the price or value of the underlying asset is equal to the strike price of the option. A call option is out-of-the-money when the price or value of the underlying asset is below the strike price. A put option is out-of-the-money when the price or value of the underlying asset is above the strike price. If an option expires at-the-money or out-of-the-money, it has no value. The short investor retains the amount paid by the long investor (the option price) and pays nothing to the long investor. Cash settlement of an in-the-money option, be it a call or a put, however, requires the short investor to pay to the long investor the difference between the strike price and the current market value of the underlying asset.
Cash settlement allows options to be based on more abstract underlying “assets” such as market indicators, stock indices, interest rates, futures contracts and other derivatives. For example, an investor may take a long position in a market index call option. In this case, the long investor receives the right to “purchase” not the index itself, but rather a cash amount equal to the value of the index (typically multiplied by a multiplier) at a specified strike value. An index call option is in-the-money when the value of the index rises above the strike value. When the holder of an in-the-money index call option exercises the option, the short investor on the opposite side of the contract is obligated to pay the long investor the difference between the current value of the index and the strike price, usually multiplied by the multiplier. If the current value of the index is less than or equal to the strike value, the option has no value. An index put option works in the same way but in reverse, having value, or being in-the-money when the value of the index falls below the strike value.
Futures contracts are another common derivative security. In a futures contract a buyer purchases the right to receive delivery of an underlying commodity or asset on a specified date in the future. Conversely, a seller agrees to deliver the commodity or asset to an agreed location on the specified date. Futures contracts originally developed in the trade of agricultural commodities, but quickly spread to other commodities as well. Because futures contracts establish a price for the underlying commodity in advance of the date on which the commodity must be delivered, subsequent changes in the price of the underlying asset will inure to the benefit of one party and to the detriment of the other. If the price rises above the futures price, the seller is obligated to deliver the commodity at the lower agreed upon price. The buyer may then resell the received product at the higher market price to realize a profit. The seller in effect loses the difference between the futures contract price and the market price on the date the goods are delivered. Conversely if the price of the underlying commodity falls below the futures price, the seller can obtain the commodity at the lower market price for delivery to the buyer while retaining the higher futures price. In this case the seller realizes a profit in the amount of the difference between the current market price on the delivery date and the futures contract price. The buyer sees an equivalent loss.
Like options contracts, futures contracts may be settled in cash. Rather than actually delivering the underlying asset, cash settlement merely requires payment of the difference between the market price of the underlying commodity or asset on the delivery date and the futures contract price. The difference between the market price and the futures price is to be paid by the short investor to the long investor, or by the long investor to the short investor, depending on which direction the market price has moved. If the prevailing market price is higher than the contract price, the short investor must pay the difference to the long investor. If the market price has fallen, the long investor must pay the difference to the short investor.
Again, like options, cash settlement allows futures contracts to be written against more abstract underlying “assets” or “commodities,” such as market indicators, stock indices, interest rates, futures contracts and other derivatives. For example, an investor may take a long position in a market index futures contract. In this case, the long investor “buys” the index at a specified futures price (i.e. a future value of the index on the “delivery” date). The index based futures contract is cash settled. One party to the contract pays the difference between the futures price and the actual value of the index (often multiplied by a specified multiplier) to the other investor depending on which direction the market has moved. If the value of the index has moved above the futures price, or futures value, the short investor pays the difference the long investor. If the value of the index has moved below the futures price, or futures value the long investor pays the difference to the short investor.
Cash settlement provides great flexibility regarding the types of underlying assets that derivative investment instruments may be built around. Essentially any variable whose value is subject to change over time, may serve as the underlying asset for a derivative investment instrument. While standard derivatives may be based on many different underlying assets, there is a need for derivative investment instruments that relate to the financial health of various organizations.